The recession may have done a number on carriers' capital spending plans, but it hasn't stopped Internet traffic from soaring to new heights. Research firm TeleGeography recently estimated that net traffic has grown at a 79% clip in 2009 -- up from 61% growth in 2008. That trend could power huge profits for an upstart chipmaker.
Ethernet hits the big time
Carriers need cheaper ways to deliver and aggregate all that booming Internet traffic. That's a big reason why Ethernet, a technology long used in home and business networks, is now displacing more expensive and less flexible legacy technologies in carrier networks. AT&T (NYSE:T) and Verizon (NYSE:VZ), among many others, are using Ethernet to deliver fiber-optic connections to businesses, and to shuffle traffic around large metropolitan areas.
Thanks to the huge investments made in older technologies, there's still a lot of market share left for Ethernet to gain. In turn, that means there should be plenty of growth in the market for the switches and routers that handle carrier Ethernet traffic. Infonetics Research sees the carrier Ethernet equipment market doubling to $34 billion between 2008 and 2013.
But an investor looking to play this growth story can't effectively do so through leading equipment vendors such as Cisco Systems (NASDAQ:CSCO), Juniper Networks (NASDAQ:JNPR), and Alcatel-Lucent (NYSE:ALU). These companies are just too diversified. A small Israeli chip company, on the other hand, does represent a "pure play" investment in the carrier Ethernet market -- and its valuation doesn't look too bad, either.
EZChip's march forward
Over the last few years, EZChip Semiconductor (NASDAQ:EZCH) has taken a growing share of the market for network processors, which act as the brains for the most powerful carrier Ethernet switches and routers. From Q1 2006 onward, the company saw revenue increase sequentially in every quarter until Q2 2009, when the recession took its toll. But Q3 revenue is expected to reach a new high, and the consensus revenue estimate for 2010 calls for a 38% increase. As EZChip's revenue has grown, so has its profitability; the company expects its annual operating margin to top 20% this year.
EZChip owes its success to first-rate engineering. The company's current top-of-the-line product, the NP-3, can handle 30 gigabits per second of data, while the forthcoming NP-4 will handle 100 gigabits per second. And with each processor generation, EZChip has been steadily enhancing its products with functionality previously handled by other chips, bringing down both costs and power consumption. The company's chips have been used in equipment from Cisco, Juniper, Ericsson, Ciena, and Chinese giant Huawei Technologies, among others.
Recently, EZChip began sampling its NPA family of processors, which are targeted at the less powerful Ethernet boxes that feed into the more costly equipment serviced by the NP family. Unlike the high end, where EZChip mostly has to compete with the in-house chip design efforts of its customers, in the low end it must also compete with independent chipmakers such as Broadcom and LSI Logic. But since the NPA chips are based on the same architecture as the NP chips, EZChip has an edge: It can offer its customers a common platform for their entire carrier Ethernet product line. The company's already claiming several major NPA design wins.
Cisco, Juniper, and the makings of a buying opportunity
However, there is one blemish on EZChip's story. Back in July, Jeffries & Co. reported that Juniper, which accounted for 46% of EZChip's revenue in the first six months of the year, is developing a proprietary network processor for its next-generation carrier Ethernet gear. As expected, this sent EZChip's shares plunging, but the news might not be as awful for the company as it first appears. Juniper's new products aren't expected to start affecting EZChip until the second half of 2010, by which point growing sales to Cisco -- the undisputed leader in the carrier Ethernet switch/router market -- are expected to more than offset them. While not publically confirmed, it's widely presumed that Cisco's next-generation carrier Ethernet platform, the ASR 9000, relies heavily on EZChip's processors.
Thanks to the expected ramp from Cisco, along with demand from other customers, Jeffries still sees EZChip delivering 16% revenue growth in 2011. And while revenue from Juniper involves traditional chip sales carrying a gross margin of about 65%, revenue from a customer believed to be Cisco involves royalties paid by Marvell Technology (NASDAQ:MRVL), which is responsible for manufacturing all of EZChip's Cisco products, and thus carries a 100% gross margin. This is a big reason why Jeffries sees EZChip's earnings per share going from $0.44 in 2009 to $0.92 in 2011.
However, if the less powerful NPA line gains traction, and the ASR 9000 helps Cisco regain some of the market share it's lost in recent years, I think both the revenue and earnings forecasts for EZChip could be conservative.
It might also be a mistake to write off EZChip's business with Juniper as a lost cause. The new switch/router line cards for which Juniper plans to use its own chipset will, according to Jeffries, top out at a speed of 80 gigabits/second. The company claims it's starting trials on a 100 gigabits-per-second chip later this year. Cisco, thanks to its use of the NP-4, plans on introducing the ASR 9000 line of cards, which can reach 400 gigabits/second. It looks as if Cisco turned to EZChip in part because the former felt it needed more horsepower to stay competitive on the high end. Juniper could eventually come back for the same reason.
Once you factor out EZChip's $55 million in net cash, the company is left with an enterprise value of roughly $11 per share. For a company that I think could easily deliver more than $1 a share in 2011 earnings, and show healthy growth in following years as the carrier Ethernet transition continues to unfold, that strikes me as a pretty reasonable price.
